Aggregate demand

Economists use a variety of models to explain how national income is determined, including the
aggregate demand - aggregate supply (AD - AS) model. This model is derived from the basic
circular flow concept, which is used to explain how income flows between households and firms.

Aggregate demand (AD)

Aggregate demand (AD) is the total demand by domestic and foreign households and firms for
an economy's scarce resources, less the demand by domestic households and firms for resources
from abroad.

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Aggregate demand consists of the amount households plan to spend on goods (C), plus planned
spending on capital investment, (I) + government spending, (G) + exports (X) minus imports (M)
from abroad. The standard equation is:

AD = C + I + G + (X M)

Aggregate demand and the circular flow

Aggregate demand can be illustrated by reference to the circular flow of income:

Prices and output

The AD - AS model shows how changes in the level of AD and AS affect an economys national
output (income) and its price level.

Example of aggregate demand

Aggregate demand PRICE
AD can be found by C I G X M AD
LEVEL
adding-up the value 200 300 50 100 50 450
of all the individual
components at 180 320 60 105 100 425
various average price 160 340 70 110 150 400
levels. 140 360 80 115 200 375
120 380 90 120 250 350
100 400 100 125 300 325
80 420 110 130 350 300
60 440 120 135 400 275

Exercise calculate AD.

Answer

AD and the price level:

Apart from imports, the components of AD are inversely related to prices. Each component
responds differently to changes in prices, in other words they have different elasticities with
respect to the price level.

For example, we can assume that overseas demand is elastic with respect to price, because
overseas consumers can choose from many global suppliers. This makes them highly sensitive to
changes in the prices of imported products.

The aggregate demand curve

The AD curve shows the relationship between AD and the price level. It is assumed that the AD
curve will slope down from left to right. This is because all the components of AD, except
imports, are inversely related to the price level.
For convenience, the AD curve is normally drawn as a straight line, though it can be argued that
it is more likely to be non-linear, many suggesting it has a rectangular hyperbola shape.

It is also claimed that the downward slope of the AD curve reflects 'normal' macro-economic
conditions, and that in a deep recession, the AD curve could become vertical.

Trade, liquidity and wealth effects

The AD curve slopes down because the components of AD are inversely related to the price
level. Price changes have a number of important affects on aggregate behaviour of households
and firms.

There are three main effects to consider.

The price level and international trade the trade effect

The first effect, on overseas trade, is perhaps the most obvious one. A rise in domestic prices
makes exports less competitive and imports more competitive; hence exports (X) are likely to
fall and imports (M) are likely to rise. Both of these reactions combine to create a trade effect,
with lower aggregate demand at the higher price level.

The price level and liquidity the liquidity/interest rate effect

When the price level increases, households and firms need to spend more money to continue to
consume the scarce resources they need. This makes them relatively short of cash than they
were at the lower price level. The liquidity of an asset refers to how easily it is converted to cash,
with cash itself being perfectly liquid. The loss of liquidity associated with a rise in the price
level forces some households and firms to borrow from banks, which reduces the liquidity of
banks. In response, banks are likely to raise interest rates as compensation for this lost liquidity.
The banks need to keep a certain amount of their reserves in a highly liquid form to meet any
unexpected increase in demand for cash.

As a result of the lost liquidity, interest rates are forced to rise, and both household and corporate
spending may fall. Hence, aggregate demand is lower at the higher price level.

The price level and the value of wealth the wealth effect

Given that interest rates will rise as financial markets readjust to the higher price level, there are
likely to be further knock on effects on household (and corporate) wealth. Higher rates may
lead to a fall in house prices, or at least slow-down house price inflation, and create a negative
wealth effect. The same may be true for those households and firms that rely on income from
shares. Rising interest rates tend to reduce corporate profits and reduce share values - again
creating a negative wealth effect. A lower price level will, of course, have the reverse effect, that
is to create a positive wealth effect on AD. The combined effect of these wealth effects is to alter
consumer and corporate spending, and hence alter the level of AD.

When combined, the above effects explain why aggregate demand responds inversely to changes
in the price level.

These effects should not be confused with other exogenous affects, which will shift the whole
position of the AD curve.